With global equity indices pushing on to new highs and the spread between corporate and government debt yields very tight relative to history, investors clearly believe in a near perfect recovery in economic and investment terms. The consensus, currently, is heavily skewed towards the view that demand, growth and profits will continue to surprise positively in the near term, but after a short period of above trend growth and inflation this year (and extending into next), both growth and inflation will revert to historic trends.
So, it was interesting to observe the tremor that rippled through the markets when the Federal Reserve Chairman said at a scheduled press conference that the Federal Open Market Committee (FOMC) were now beginning to focus more on the inflation outlook and less on ameliorating the impacts of COVID-19 induced lock downs. This, surely, is a prerequisite in the road to recovery. Nonetheless, the market volatility observed over the Federal Reserve’s very modest recalibration of policy emphasis was considerable.
From the bond market investors’ perspective, the outlook for the global economy over the medium term is anaemic at best. The amount of debt which has been, and continues to be, built up is such that central banks will be unable to put up interest rates (even marginally) as any increase in debt financing costs will drive economies into the buffers.
Equity investors, however, sees low interest rates as a justification for high valuations as discount rates are low, but assume growth will proceed at such a pace to enable further earnings upgrades and debt reduction, without giving much weight to factors which could derail this narrative. Flows of money into equities has been strong and positioning in the asset class is high relative to history.
With business confidence surveys at, or close to, all-time highs, it is only a matter of time before these fall to more mundane levels and when this happens, confidence in the continuing earnings upgrade narrative may weaken.
The demand for low interest rates ‘forever’ will periodically come into conflict with policymakers’ clear desire, albeit unobtainable, for a return of consistent and stable price rises (to deflate debt away). Already, investors are challenging the Federal Reserve’s resolve concerning their new inflation policy, the so called ‘flexible average inflation-targeting’ regime, which allows inflation to overshoot the 2% target for considerable periods of time, if there has been a prolonged undershoot of the target. What if the Federal Reserve is serious about this? Inflation is certainly a tourist in developed countries (given the weight of debt, demographics, etc), but will it outstay the visa issued to it by investors?
One must also question the wisdom of the US Treasury continuing to buy $120bn worth of assets each month when bond and equity valuations are as high as they are. The necessity to ensure functioning markets during the initial COVID-19 lockdown market seizure by introducing emergency quantitative easing is surely well behind us now and additional asset buying is distorting price discovery. Nonetheless, any suggestion of tapering the quantum of quantitative easing will, no doubt, increase volatility.